Production Cost and Cost Firm in the Firm 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 2 Cost and Profit Producers: Maximize profit Opportunity cost –All resources have an opportunity cost Explicit costs –Opportunity cost of resources employed by a firm –Cash payments –On the accounting statement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 3 Cost and Profit Implicit costs –A firm’s opportunity cost of using its own resources or those provided by its owners –Without a corresponding cash payment –Not on the accounting statement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Measures of Profit Accounting profit –Total revenue minus explicit costs Economic profit –Total revenue minus all costs (implicit and explicit) Opportunity cost of all resources Normal profit –Accounting profit earned when all resources earn their opportunity cost 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 1 5 Wheeler Dealer Accounts, 2012 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Production in the Short Run Variable resources –Can be varied in the short run to increase or decrease production Fixed resources –Cannot be varied in the short run Short run –At least one resource is fixed Long run –No resource is fixed 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Diminishing Marginal Returns Total product –A firm’s total output Production function –Relationship between amount of resources employed and total product Marginal product –Change in total product from an additional unit of resource –Other things constant 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Diminishing Marginal Returns Increasing marginal returns –Marginal product increases Diminishing marginal returns –Marginal product decreases Law of diminishing marginal returns –As more of a variable resource is added to a given amount of another resource –Marginal product eventually declines Could become negative 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 2 9 The Short-Run Relationship Between Units of Labor and Tons of Furniture Moved Marginal product increases as the firm hires each of the first three workers, reflecting increasing marginal returns. Then marginal product declines, reflecting diminishing marginal returns. Adding more workers may, at some point, actually reduce total product (as occurs here with an eighth worker) because workers start getting in each other’s way. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 3 10 The Total and Marginal Product of Labor Total product (tons/day) 510 Workers per day Workers per day Marginal product (tons/day) Total product Marginal product Negative marginal returns Diminishing but positive marginal returns Increasing Marginal returns (a) Total product (b) Marginal product When marginal product is rising, total product increases by increasing amounts. When marginal product is falling but still positive, total product increases by decreasing amounts. When marginal product equals 0, total product is at a maximum. When marginal product is negative, total product is falling. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Fixed cost, FC –Any production cost that is independent of the firm’s rate of output Variable cost, VC –Any production cost that changes as the rate of output changes Total cost, TC = FC + VC 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Marginal cost, MC = ∆TC/∆q –Change in total cost resulting from a one- unit change in output Changes in MC –Reflect changes in marginal productivity Increasing marginal returns –MC falls Diminishing marginal returns –MC increases 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 4 13 Short-Run Total and Marginal Cost Data for Smoother Mover Because of increasing marginal returns from the first three workers, marginal cost declines at first, as shown in column (6). Because of diminishing marginal returns beginning with the fourth worker, marginal cost starts increasing. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Fixed cost curve –Straight horizontal line Variable cost curve –Starts at the origin Total cost curve –Fixed cost curve + variable cost curve Slope of total cost curve –Marginal cost 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 5 15 Total and Marginal Cost Curves for Smoother Mover 200 $500 Total dollars 25 Cost per ton $50 Marginal cost 915Tons per day06312 Fixed cost Total cost Tons per day Variable cost Fixed cost In panel (a), fixed cost is $200 at all levels of output. Variable cost starts from the origin and increases slowly at first as output increases. When the variable resource generates diminishing marginal returns, variable cost begins to increase more rapidly. Total cost is the vertical sum of fixed cost and variable cost. In panel (b), marginal cost first declines, reflecting increasing marginal returns from the variable resource (labor in this example) and then increases, reflecting diminishing marginal returns. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Average Cost in the Short Run Average variable cost, AVC = VC/q –Variable cost divided by output Average fixed cost, AFC = FC/q –Fixed cost divided by quantity Average total cost, ATC = TC/q –Total cost divided by output –ATC = AFC + AVC 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Average Cost in the Short Run When MC < average cost –The marginal pulls down the average When MC > average cost –The marginal pulls up the average U-shape of average cost curves –Law of diminishing marginal returns 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 6 18 Short-Run Total, Marginal, and Average Cost Data for Smoother Mover Marginal cost first falls then increases because of increasing then diminishing marginal returns from labor. As long as marginal cost is below average cost, average cost declines. Once marginal cost exceeds average cost, average cost increases. Columns (4), (5), and (6) show the relation between marginal and average costs. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 7 19 Average and Marginal Cost Curves for Smoother Mover Tons per day $ Cost per ton ATC AVC MC Average variable cost and average total cost curves first decline, reach low points, and then rise. Overall, they have U shapes. When marginal cost is below average variable cost, average variable cost is falling. When marginal cost equals average variable cost, average variable cost is at its minimum. When marginal cost is above average variable cost, average variable cost is increasing. The same relationship holds between marginal cost and average total cost. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Long run –Planning horizon –All resources can be varied Firms plan for the long run Firms produce in the short run 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Economies of scale –Forces that reduce a firm’s average cost –As the scale of operation increases in the long run Diseconomies of scale –Forces that may eventually increase a firm’s average cost –As the scale of operation increases in the long run 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Long-run average cost curve –Indicates the lowest average cost of production At each rate of output when the scale of the firm varies –Planning curve –U-shaped Economies of scale Diseconomies of scale 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 8 23 Short-Run Average Total Cost Curves Form the Long-Run Average Cost Curve, or Planning Curve Cost per unit 0qqaqa q’Output per periodqbqb S S’ M M’ L L’ Curves SS’, MM’, and LL’ show short-run average total costs for small, medium, and large plants, respectively. For output less than q a, average cost is lowest when the plant is small. Between q a and q b, average cost is lowest with a medium-size plant. If output exceeds q b, the large plant offers the lowest average cost. The long-run average-cost curve connects these low cost segments of each curve and is identified as SabL’. a b © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 9 24 Many Short-Run Average Total Cost Curves Form a Firm’s Long-Run Average Cost Curve, or Planning Curve ATC 1 ATC 2 0qq’Output per period Cost per unit $ b ATC 3 ATC 4 ATC 5 ATC 6 ATC 7 ATC 8 ATC 9 ATC 10 Long-run average cost c a With many possible plant sizes, the long-run average cost curve is the envelope of portions of the short-run average cost curves. Each short-run curve is tangent to the long-run average cost curve. Each point of tangency represents the least-cost way of producing that rate of output. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Constant long-run average cost –Over some range of output –Long-run average cost neither increases nor decreases with changes in firm size –No economies of scale –No diseconomies of scale 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Long-Run Average Cost Curve Cost per unit 0AOutput per periodB Economies of scale Long-run average cost Diseconomies of scale Constant average cost Up to output level A, long-run average cost falls as the firm experiences economies of scale. Output level A is the minimum efficient scale—the lowest rate of output at which the firm takes full advantage of economies of scale. Between A and B, the average cost is constant. Beyond output level B, long-run average cost increases as the firm experiences diseconomies of scale. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economies & Diseconomies of Scale Plant level –Particular location Firm level –Collection of plants 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Production function –Identifies the most that can be produced –Per time period –Using various combinations of resources –For a given state of technology Technologically efficient production –Producing the maximum possible output given the combination of resources used That same output could not be produced with fewer resources 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Production Function Using Labor and Capital: Production per Month © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Isoquant –All technologically efficient combinations of two resources That produce a certain (constant) rate of output Properties of isoquants –Farther from origin: greater output rates –Negative slope –Don’t intersect –Convex to the origin 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Isoquants 05 Units of labor per month 10 Units of capital per month 5 10 Q 1 (290) Q 2 (415) Q 3 (475) a b c d e h f g Isoquant Q 1 shows all technologically efficient combinations of labor and capital that can be used to produce 290 units of output. Isoquant Q 2 reflects 415 units, and Q 3 reflects 475 units. Each isoquant has a negative slope and is convex to the origin © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Slope of an isoquant –Measures the ability of additional units of one resource To substitute in production for another resource –Negative 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Marginal rate of technical substitution –MRTS –Rate at which labor substitutes for capital without affecting output –Absolute value of the slope of the isoquant –MRTS = MP L /MP C 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Isocost lines –All combinations of capital and labor a firm can hire for a given total cost –Are parallel – reflect the same relative resource prices Slope of isocost line –Negative –Price of labor divided by price of capital 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Isocost Lines Units of labor per month 5 10 Units of capital per month TC = $15,000 TC = $19,000 TC = $22,500 Slope = -w/r = -$1,500/$2,500 = -0.6 Each isocost line shows combinations of labor and capital that can be purchased for a given amount of total cost. The slope of each equals the negative of the monthly wage rate divided by the rental cost of capital per month. Higher costs are represented by isocost lines farther from the origin. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Minimum cost to produce a given output –Tangency between isocost line and isoquant –Same slope = MRTS = ratio of input prices = w/r The firm adjusts resource use so that –Rate at which one input substitutes for another in production = rate at which one resource exchanges for another in resource markets 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Optimal Combination of Inputs Q 1 (290) Q 2 (415) Q 3 (475) f Units of labor per month 5 10 Units of capital per month TC = $19,000 a e At point e, isoquant Q2 is tangent to the isocost line. The optimal combination of inputs is 6 units of labor and 4 units of capital. The most that can be produced for $19,000 is 415 units. Another way of looking at this is that point e identifies the least costly way of producing 415 units. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix Production and Cost Expansion path –Connect the tangency points between isoquants and isocost lines Least-cost input combinations for producing several output rates –Slopes upward –Lowest long-run total cost for each rate of output 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit A Firm’s Expansion Path Expansion path Q2Q2 LL’ 0 Units of labor per month C Units of capital per month Q4Q4 Q3Q3 Q1Q1 d h TC 3 TC 2 TC 1 TC 4 a b c Points of tangency between isoquants and isocost lines identify the least costly resource combination of producing each particular quantity of output. Connecting these tangency points traces out the firm’s expansion path, which usually slopes up to the right, indicating that more of both goods is needed to increase output. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.